Hedge funds have become unlikely fiscal watchdogs

Their exposure to both short and long U.S. Treasuries reached a record-breaking $3.8 trillion in March, more than doubling since 2022, according to the Office of Financial Research (OFR), accounting for approximately 13% of the total market.

The Treasury market is the bedrock of the global financial system and underpins every other financial market. Regulators and central banks are sounding the alarm that hedge funds taking highly-leveraged positions can disrupt its functioning.

Yet, with a newfound ability to save or sink bond markets, intentional or not, hedge funds have also gained political sway. Recent instances of rapid deleveraging have worsened financial shocks, but it's precisely this chaos that has forced leaders to backtrack on risky policies.

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter," Bill Clinton's chief strategist James Carville said in 1993, regarding Wall Street's response to the then-president's economic policies. "But now, I would like to come back as the bond market. You can intimidate everybody,"

So, are hedge funds Wall Street's latest bond vigilantes, or dangerous market destabilizers?

How hedge funds got drunk on Treasuries

Key to understanding hedge funds' burgeoning political influence is understanding why they've poured into bond markets to begin with.

The Federal Reserve rapidly began hiking interest rates in 2022, climbing from near-zero to 5.5% in less than a year — the highest level in more than two decades. Surging borrowing costs caused large swings in Treasury prices.

Those swings widened the “basis” gap between Treasuries in the cash market and the futures contract on that bond. In theory, the two prices should track closely, because a futures contract is simply a promise to deliver the bond later.

Big rate swings widen the basis gap because investors use Treasury futures to hedge or speculate. That surging demand can push futures prices out of line with cash bonds.

Hedge funds arbitrage this tiny difference, known as basis trading.

They use repo markets to borrow enormous amounts of money to buy “cheaper” bonds, while selling more “expensive” futures contracts, thus transforming small profits into large ones. The top 10 hedge funds account for 40% of total repo borrowing and have leverage ratios of 18-to-1, according to OFR data as of March 2024.

Basis trades can “enhance U.S. Treasury market functioning by increasing liquidity and price discovery while lowering the cost of government borrowing,” Beth M. Hammack, president and CEO of the Federal Reserve Bank of Cleveland, said in February.

“These trades provide liquidity in calm times, but disrupt it in tumultuous times,” Richard Berner, a finance professor at NYU and the first director of the OFR, told the Financial Times in April.

'You can intimidate everybody'

The chaos that's ensued from the rapid unravelling of these trades have forced political leaders to U-turn on highly controversial economic policies.

When President Donald Trump announced reciprocal tariffs on U.S. imports on April 2, the bond market did not take to the economic uncertainty well.

Concluding this could worsen already-high inflation and keep interest rates higher for longer, investors dumped their bonds. At the same time, demand for Treasury futures grew stronger, driving up their price further.

This widened the basis relative to hedge fund positions, suffering losses on both the bonds they held, and on the futures they shorted. As their trades were so heavily leveraged, margin calls were significant. Once lenders demanded more collateral to account for the lost value on their positions, funds were forced to unwind their trades. The price of 10-year Treasuries fell by 8% in one week.

“Hedge fund deleveraging likely amplified the move,” JPMorgan $JPM analysts wrote in April. 

Within days of their debut, Trump abruptly announced a 90-day pause on tariffs, acknowledging that the bond market was “getting a little queasy.”

Similar episodes of bond-market vigilantism have occurred in the U.K. gilt (government bond) market, where hedge funds account for around 60% of trading volumes.

The most notable case was that of former Prime Minister Liz Truss. In 2022, after Truss unveiled sweeping unfunded tax cuts and large spending promises. A gilt sell-off ensued.

Less than a week later, the Bank of England announced emergency gilt purchases to stabilize the market, warning: “Were dysfunction in this market to continue or worsen, there would be a material risk to U.K. financial stability.” Just weeks after that intervention, Truss resigned — having served only 49 days as prime minister.

Gilt markets sprang into action again last month, following a fraught moment in Parliament. Chancellor of the Exchequer Rachel Reeves appeared to cry behind Prime Minister Keir Starmer, who hesitated to fully back her. The 10-year gilt yield immediately jumped by 22 basis points — the biggest one-day surge since the Truss turmoil — as investors feared the fiscally disciplined Reeves was on the cusp of losing her role overseeing the government’s finances.

Within a day, Starmer publicly reaffirmed his support for Reeves, declaring she “will be chancellor for a very long time to come." At this point, gilt yields retreated.

“The bond market has rescued Rachel Reeves from Keir Starmer,” wrote The Newstatesman’s Will Dunn later that day. 

Making the bad times worse

Describing how he felt watching hedge funds unwind their trades in response to Trump's tariffs, Bill Campbell, portfolio manager at asset manager DoubleLine, told Reuters: “You started to get the warning signs that there was potentially stress building up in the system, and had it continued, then you start to run the risk that bigger things would happen.”

The outbreak of Covid-19 gave a glimpse into just how quickly "bigger things" could transpire — a lesson that haunts regulators.

In the three years prior to 2022, hedge funds had almost doubled their Treasury exposure, aligning with a 1.75% rate hike.

When the pandemic hit, panicked global investors wanted cash, fast. Instead of buying up safe-haven Treasuries, investors sold them to raise liquidity.

Once again, the basis widened against hedge funds’ positions. By dumping Treasuries, they worsened the sell-off. By mid-March, the Fed was forced to buy over $1.6 trillion in Treasuries within weeks in order to stabilize the market.

Hedge funds are at risk of their trades “backfiring, stoking financial stability risks across the world,” the IMF wrote in a recent report on global financial stability. Funds had dumped more than half a trillion dollars in Treasuries by the end of 2020.

Spillover effects

Love them or loathe them, Treasury basis traders aren't slowing down. The U.K. bought $48.7 billion of Treasuries in June — the largest purchase of any country — maintaining its rank as the second-largest foreign holder. The U.K. is considered to be a custody country, meaning it's used by hedge funds for custody services, similar to the Cayman Islands and the Bahamas.

While hedge funds may have blunted the impact of Truss' unfunded tax cuts, or Trump's sweeping tariffs, regulators argue that a handful of profit-motivated, risk-tolerant hedge funds cannot be trusted with the bedrock of the financial system.

Last month, the Financial Stability Board (FSB) called on regulators across the G20 to consider setting leverage limits for non-bank financial firms in government bond markets.

"Today's financial system is too interconnected to be sanguine about potential spillover effects from the non-banking sector," the Fed's Hammack said in April. "No one who remembers 2008 and the run on structured investment vehicles, AIG, and Lehman Brothers should think that moving risky assets to non-banks is any guarantee of financial stability."